chapter 10 · irwin/mcgraw-hill © the mcgraw-hill companies, inc., 2001 $ irwin/mcgraw-hill © the...

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Chapter 10

Reporting and Interpreting Bonds


Business Background

The mixture of debt and equity used to finance a company’s operations is called the capital

structure:

Debt - funds from creditors

Equity - funds from owners


Significant debt needs of a company are often filled

by issuing bonds.

Significant debt needs of a company are often filled

by issuing bonds.

Business BackgroundCapital Structure - Bonds

Bonds Cash


Business Background

Bonds can be traded on

established exchanges that

provide liquidity to

bondholders.

Bonds can be traded on

established exchanges that

provide liquidityliquidity to

bondholders.

As liquidity increases . . .

. . . Cost of borrowing decreases.


Business Background

Advantages of bonds:• Bonds are debt, not equity, so the

ownership and control of the company are not diluted.

• Interest expense is tax-deductible.• The low interest rates on bonds

allow for positive financial leverage.

Advantages of bonds:• Bonds are debt, not equity, so the

ownership and control of the company are not diluted.

• Interest expense is tax-deductible.• The low interest rates on bonds

allow for positive financial leverage.


Business Background

Disadvantages of bonds:• The scheduled interest

payments are legal obligations and must be paid each period.

• A single, large principal payment is required at the maturity date.

Disadvantages of bonds:• The scheduled interest

payments are legal obligations and must be paid each period.

• A single, large principal payment is required at the maturity date.


Key Ratio Analysis

The debt-equity ratio is an important measure of the balance between debt and

equity.

High debt-equity ratios indicate more leverage and risk.

Debt/equity ratio = Total liabilities Owners' equity

Debt/equity ratio = Total liabilities Owners' equity


Characteristics of Bonds Payable

Company Issuing Bonds


$ Bond Issue Price $Investor Buying Bonds

Investor Buying Bonds

Bond Certificate

At Bond Issuance Date

Bonds payable are long-term debtfor the issuing company.





PeriodicInterest Payments$ $



Face Value Payment at End of

Bond Term$ $


1. Face Value = Maturity or Par Value, Principal2. Maturity Date3. Stated Interest Rate4. Interest Payment Dates5. Bond Date


Other Factors:6. Market Interest Rate7. Issue Date

BOND PAYABLE

Face Value $1,000 Interest 10%6/30 & 12/31

Maturity Date 1/1/10Bond Date 1/1/01



• When issuing bonds, potential buyers of the bonds are given a prospectus.

• The company’s bonds are issued to investors through an underwriter.

• The trustee makes sure the issuer fulfills all of the provisions of the bond indenture.

• When issuing bonds, potential buyers of the bonds are given a prospectus.

• The company’s bonds are issued to investors through an underwriter.

• The trustee makes sure the issuer fulfills all of the provisions of the bond indenture.


Bond Classifications

• Debenture bondsNot secured with the pledge of a specific asset.

• Callable bondsMay be retired and repaid (called) at any time at the option

of the issuer.• Redeemable bonds

May be turned in at any time for repayment at the option of the bondholder.

• Convertible bondsMay be exchanged for other securities of the issuer

(usually shares of common stock) at the option of the bondholder.

•• Debenture bondsDebenture bondsNot secured with the pledge of a specific asset.

•• Callable bondsCallable bondsMay be retired and repaid (called) at any time at the option

of the issuer.•• Redeemable bondsRedeemable bonds

May be turned in at any time for repayment at the option of the bondholder.

•• Convertible bondsConvertible bondsMay be exchanged for other securities of the issuer

(usually shares of common stock) at the option of the bondholder.


• Senior Debt receives preference over other creditors in the event of bankruptcy or default.

• Subordinated Debt is riskier than senior debt.

•• Senior Debt Senior Debt receives preference over other creditors in the event of bankruptcy or default.

•• Subordinated Debt Subordinated Debt is riskier than senior debt.

Bond Classifications


Measuring Bonds Payable and Interest Expense

Present Value of the Principal (a single payment)+ Present Value of the Interest Payments (an annuity) = Issue Price of the Bond

Present Value of the Principal (a single payment)+ Present Value of the Interest Payments (an annuity) = Issue Price of the Bond

The issue price of the bond is determined by the market, based on the time value of money.

The interest rate used to compute the present value is the market interest ratemarket interest rate.


Measuring Bonds Payable and Interest Expense

The stated ratestated rate is only used to compute the periodic interest payments.

Interest = Principal × Stated Rate × TimeInterest = Principal × Stated Rate × Time


Bond Premium and Discounts

Interest Bond Accounting forRates Price the Difference

Stated Market Bond Par Value There is no differenceRate Rate Price of the Bond to account for.

Stated Market Bond Par Value The difference is accountedRate Rate Price of the Bond for as a bond discount.

Stated Market Bond Par Value The difference is accountedRate Rate Price of the Bond for as a bond premium.





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Issuing Bonds

On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually.

The market rate is 8% annually.

On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually.

The market rate is 8% annually.

Are Harrah’s bonds issued at par, at a discount, or at a premium?


On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6%

annually. The bonds mature in 10 years and interest is paid semiannually. The

market rate is 8% annually.




Issuing Bonds




Stated Market Bond Par Value The difference is accountedRate Rate Price of the Bond for as a bond discount.< <


Issuing Bonds







Compute the issue price of Harrah’s bonds.


Present ValueSingle Amount = Principal × Factor

Issuing Bonds

!Compute the present value of the principal.

Use the present value of a single amount table to find the

appropriate factor.


appropriate factor.


Present ValueSingle Amount = Principal × Factor, i=4.0%

Issuing Bonds


Use the market rate of 8% to determine present value. Interest is

paid semiannually, so the rate is i=4% (8% ÷ 2 interest periods per year).

Use the market rate of 8% to determine present value. Interest is

paid semiannually, so the rate is i=4% (8% ÷ 2 interest periods per year).


Present ValueSingle Amount = Principal × Factor, i=4.0%, n=20

Issuing Bonds


Though the maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20

(10 years × 2 periods per year).

Though the maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20

(10 years × 2 periods per year).


Issuing Bonds


Present ValueSingle Amount = Principal × Factor, i=4.0%, n=20

= 1,000,000$ × 0.4564 = 456,400$


Present ValueAnnuity = Payment × Factor

Issuing Bonds

"Compute the present value of the interest payments.

The interest payment is computed as:

$1,000,000 × 6% × 6/12

= $30,000


$1,000,000 × 6% × 6/12

= $30,000


Present ValueAnnuity = Payment × Factor, i=4.0% , n=20

= 30,000$


= 30,000$

Issuing Bonds


Use the same i=4.0% and n=20 used for the present value of the principal,

but use the present value of an annuity table.

Use the same i=4.0% and n=20 used for the present value of the principal,

but use the present value of an annuity table.


Issuing Bonds



= 30,000$ × 13.5903 = 407,709$


= 30,000$ × 13.5903 = 407,709$

Now, the issue price of the bonds can be computed.



Issuing Bonds

#Compute the issue price of the bonds.

456,400$ Present Va lue of the Principa l + 407,709 Present Va lue of the Interest

= 864,109$ Present Va lue of the Bonds








Issuing Bonds


The $864,109 is less than the face amount of

$1,000,000, so the bonds are issued at a discount of

$135,891.

The $864,109 is less than the face amount of

$1,000,000, so the bonds are issued at a discount of

$135,891.


GENERAL JOURNAL Page 97Date Description Debit Credit

May 1 Cash 864,109Discount on Bonds Payable 135,891 Bonds Payable 1,000,000to record issuance of bonds

Recording BondsIssued at a Discount

$Prepare the journal entry to record the issuance of the bonds.

This is a contra-liability account and appears in the liability section of the balance sheet.

This is a contra-liability account and appears in the liability section of the balance sheet.


Harrah'sPartial Balance Sheet

At May 1, 2001

Long-Term LiabilitiesBonds Payable, 6% 1,000,000$ Due April 30, 2011 Less: Bond Discount (135,891) Total L-T Liabilities 864,109$

Bonds Issued at a DiscountFinancial Statement Presentation

The discount The discount will be will be

amortizedamortizedover the 10over the 10--

year life of the year life of the bonds.bonds.



At May 1, 2001



At May 1, 2001



Two methods Two methods of amortization of amortization are commonly are commonly

used:used:StraightStraight--lineline

ororInterest MethodInterest Method


Straight-Line Amortization of Bond Discount

!Identify the amount of the bond discount.

"Divide the bond discount by the number of interest periods.

#Include the discount amortization amount as part of the periodic interest expense entry.The discount will be reduced to

zero by the maturity date.

!Identify the amount of the bond discount.

"Divide the bond discount by the number of interest periods.

#Include the discount amortization amount as part of the periodic interest expense entry.The discount will be reduced to

zero by the maturity date.



Harrah’s issued their bonds on May 1, 2001. The discount was $135,891. The bonds have a 10-year maturity

and $30,000 interest is paid semiannually.

Compute the periodic discount amortization using the straight-line method.












Discount Total Number ofAmortization = Discount ÷ Interest Periods











= 135,891$ ÷ 20

= 6,795$ per period (rounded)


= 135,891$ ÷ 20

= 6,795$ per period (rounded)



Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on November 1, 2001.

Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on November 1, 2001.


Nov. 1 Interest Expense 36,795 Discount on Bonds Payable 6,795 Cash 30,000To record payment of interest



As the discount is

amortized, the carrying

amount of the bonds

increases.

Harrah'sPartial Balance SheetAt November 1, 2001


Harrah'sPartial Balance SheetAt November 1, 2001



Zero Coupon Bonds

• Zero coupon bonds do not pay periodic interest.

• Because there is no interest annuity . . .

• This is called a deep discount deep discount bondbond.

PV of the Principal = Issue Price of the BondsPV of the Principal = Issue Price of the Bonds


Issuing Bonds at a Premium









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On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is

paid semiannually. The market rate is 8% annually.



Are Harrah’s bonds issued at par, at a discount, or at a premium?










Stated Market Bond Par Value The difference is accountedRate Rate Price of the Bond for as a bond premium.> >

Let’s compute the issue price of the bonds.


Present ValueSingle Amount = Principal × FactorPresent ValueSingle Amount = Principal × Factor




appropriate factor.


appropriate factor.


Present ValueSingle Amount = Principal × Factor, i=4.0%Present ValueSingle Amount = Principal × Factor, i=4.0%



Use the market rate of 8% to determine present value. Interest is paid

semiannually, so the rate is i=4.0% (8% ÷ 2 interest periods per year).

Use the market rate of 8% to determine present value. Interest is paid

semiannually, so the rate is i=4.0% (8% ÷ 2 interest periods per year).


Present ValueSingle Amount = Principal × Factor, i=4.0% , n=20Present ValueSingle Amount = Principal × Factor, i=4.0% , n=20



The maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20

(10 years × 2 periods).

The maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20

(10 years × 2 periods).




Present ValueSingle Amount = Principal × Factor, i=4.0% , n=20

= 1,000,000$ × 0.4564 = 456,400$

Present ValueSingle Amount = Principal × Factor, i=4.0% , n=20

= 1,000,000$ × 0.4564 = 456,400$

Next, we compute the present value of the interest payments.Next, we compute the present value of the interest payments.







$1,000,000 × 10% × 6/12

= $50,000


$1,000,000 × 10% × 6/12

= $50,000



= 50,000$


= 50,000$



Use the same i=4.0% and n=20 that were used to compute the present

value of the principal. Now, however, the factor comes from the present value of an annuity table.

Use the same i=4.0% and n=20 that were used to compute the present

value of the principal. Now, however, the factor comes from the present value of an annuity table.





= 50,000$ × 13.5903 = 679,515$


= 50,000$ × 13.5903 = 679,515$





= 1,135,915$ Present Va lue of the Bonds


= 1,135,915$ Present Va lue of the Bonds



The $1,135,915 is greater than the face amount of $1,000,000, so the bonds are issued at a premium of

$135,915.

The $1,135,915 is greater than the face amount of $1,000,000, so the bonds are issued at a premium of

$135,915.



May 1 Cash 1,135,915 Bonds Payable 1,000,000 Premium on Bonds Payable 135,915


$Prepare the journal entry to record the issuance of the bonds.

This is called an adjunct account and appears in the liability section.This is called an adjunct account

and appears in the liability section.



At May 1, 2001

Long-Term LiabilitiesBonds Payable, 10% 1,000,000$ Due April 30, 2011Add: Bond Premium 135,915 Total L-T Liabilities 1,135,915$


At May 1, 2001

Long-Term LiabilitiesBonds Payable, 10% 1,000,000$ Due April 30, 2011Add: Bond Premium 135,915 Total L-T Liabilities 1,135,915$

Bonds Issued at a PremiumFinancial Statement Presentation

The The premium premium

will be will be amortizedamortized

over the 10over the 10--year life of year life of the bonds.the bonds.


Effective-Interest Amortization of Bond Discounts and Premiums

Bond Carrying Value × Market RateBond Carrying Value × Market Rate

The effective-interest method computes interest as:

Principal amount of the bonds less any unamortized discount or plus any unamortized premium.

Principal amount of the bonds less any unamortized discount or plus any unamortized premium.


Effective-Interest Amortization of Bond Discounts and Premiums

This is the same market rate used to determine the

present value of the bond.

This is the same market rate This is the same market rate used to determine the used to determine the

present value of the bond.present value of the bond.

Bond Carrying Value × Market RateBond Carrying Value × Market Rate

The effective-interest method computes interest as:


Effective-Interest Method

Recall our first example of Harrah’s. On May 1, 2001, the company issues $1,000,000 in bonds having a

stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually. The


Recall our first example of Harrah’s. On May 1, 2001, the company issues $1,000,000 in bonds having a

stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually. The



May 1 Cash 864,109Discount on Bonds Payable 135,891 Bonds Payable 1,000,000to record issuance of bonds



Principal amount of bonds 1,000,000$ Less: unamortized discount (135,891) Bond Carrying Value 864,109 Market interest rate 4.00%Interest expense - 11/1/01 34,564$

Interest is paid semi-annually, so the market rate

is 8% ÷ 2 = 4%.

Interest is paid semi-annually, so the market rate

is 8% ÷ 2 = 4%.

The cash paid to bond holders if $30,000 ($1,000,000 × 3%)

The cash paid to bond holders if $30,000 ($1,000,000 × 3%)



The journal entry to record the first interest payment is:


Nov. 1 Interest Expense 34,564 Discount on Bonds Payable 4,564 Cash 30,000To record payment of interest



The new bond carrying value of the next interest payment period is:

Principal amount of bonds 1,000,000$ Less: unamortized discount (131,327) Bond Carrying Value 868,673

Unamortized discount 135,891$ Less: amount amortized (4,564) New unamortized discount 131,327


Understanding Alternative Amortization Methods

• Effective-interest method of amortization is preferred by GAAP.

• Straight-line amortization may be used if it is not materially different from effective interest amortization.

• Effective-interest method of amortization is preferred by GAAP.

• Straight-line amortization may be used if it is not materially different from effective interest amortization.


Early Retirement of Debt

• Occasionally, the issuing company will call (repay early) some or all of its bonds.

• Gains/losses incurred as a result of retiring bonds, should be reported as an extraordinary item on the income statement.

• Occasionally, the issuing company will callcall (repay early) some or all of its bonds.

• Gains/losses incurred as a result of retiring bonds, should be reported as an extraordinary itemextraordinary item on the income statement.


End of Chapter 10

chapter 10 · irwin/mcgraw-hill © the mcgraw-hill companies, inc., 2001 $ irwin/mcgraw-hill © the...

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